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The Fight Against An Alarming Trend: Section 706(b) Motions – Part 1


There is an alarming trend facing us, and it is not the latest teen-age fashions. It is the filing of motions pursuant to 11 U.S.C. § 706(b), to convert individual nonconsumer Chapter 7 cases to Chapter 11.

Because the topic of § 706(b) motions is a bit complicated, and requires some background information to understand it, my discussion will span a multi-part series of posts. In this first post I’ll set the stage by beginning with the more commonly seen terrain of 11 U.S.C. § 707 motions to dismiss.

I. Section 707 – Dismissal Of An Individual Chapter 7 Case

11 U.S.C. § 707 is the only Code section under which the Court can dismiss an individual Chapter 7 case.

A. Subsection 707(a)

A dismissal under subsection 707(a) requires: (1) notice and a hearing, and (2) cause. There are three causes listed in § 707(a), but they are not exclusive because the list is preceded by the word, “including.” See § 102(3): “In this title — ‘includes’ and ‘including’ are not limiting …”

Anyone can seek dismissal under the first two causes, which include prejudicial delay on the part of the debtor, and failure to pay fees required under chapter 123 of title 28 (i.e., 28 U.S.C. §§ 1911 – 1932.11). By the explicit language of the statute, only the U.S. Trustee can initiate a subsection 707(a)(3) dismissal for failure to timely file the required documents.

None of these three listed causes is particularly controversial. However, since the statute uses the word, “including,” it is natural to ask what is not explicitly listed in § 707(a) that constitutes cause.

1. Is Bad Faith Cause?

Some courts have held that bad faith constitutes cause in a § 707(a) motion to dismiss. See, e.g., In re Tamecki, 229 F.3d 205, 207 (3rd Cir. 2000) (“Section 707(a) allows a bankruptcy court to dismiss a petition for cause if the petitioner fails to demonstrate his good faith in filing.”); In re Lacrosse, 244 B.R. 583, 587 (Bankr. M.D. Pa. 1999) (a Chapter 7 petition may be dismissed under § 707(a) for lack of good faith in filing the petition); In re Smith, 229 B.R. 895, 897 (Bankr. S.D. Ga.1997) (debtor’s lack of good faith in filing bankruptcy petition will constitute “cause” for dismissal of Chapter 7 case); In re Griffieth, 209 B.R. 823, 831 (Bankr. N.D. N.Y.1996) (holding dismissal was justified under § 707(a) because the debtors’ case was not filed in good faith).

However, bad faith does not appear to be cause in the Ninth Circuit.

In In re Padilla, 222 F. 3d 1184, 1191 (9th Cir. 2000), the Ninth Circuit held that bad faith does not constitute cause under § 707(a): “[W]e agree with the Eighth Circuit that bad faith as a general proposition does not provide ‘cause’ to dismiss a Chapter 7 petition under § 707(a).”

At the time of the Padilla holding, § 707(b)(3)(A) was not part of the Code. That subsection instructs the Court to consider bad faith in its analysis. However, BAPCPA did not change § 707(a), so there is still nothing in § 707(a) that even mentions bad faith. Moreover, in In re Sherman, 491 F. 3d 948 (9th Cir. 2007) — a post-BAPCPA enactment case — the Ninth Circuit again appeared to reject bad faith as a cause for dismissal under § 707(a). But see In re Quinn, 490 B.R. 607, 616 (Bankr. D. N.M. 2012):

The Court, therefore, concludes that a “bad faith filing” may constitute “cause” for dismissal of a Chapter 7 bankruptcy case under 11 U.S.C. § 707(a). A lack of good faith on the part of a debtor, whether pre-or post-petition, or both, is a relevant consideration in determining whether to dismiss a chapter 7 case under 11 U.S.C. § 707(a) for cause, and, if sufficiently egregious, may alone be sufficient to constitute cause to dismiss.

In addition, and pace the Quinn holding, a case can be made that if bad faith is included in § 707(a) analysis, it renders § 707(b)(3)(A) statutory surplusage, contrary to the Supreme Court’s “canon against surplusage[, which] is strongest when an interpretation would render superfluous another part of the same statutory scheme.” Marx v. General Revenue Corp., 133 S. Ct. 1166, 1178 (2013).

Of course, since the Court must consider bad faith in dealing with a § 707(b)(3) motion to dismiss, you might object that this § 707(a) bad faith discussion is much ado about nothing. After all, the Court can just use § 707(b)(3) to dismiss a bad faith case.

However — per § 707(b)(1) — § 707(b) only applies to debtors whose debts are primarily consumer debts, whereas § 707(a) lacks that restriction. Therefore, if the debtor’s debts are not primarily consumer debts, § 707(b)(3) is off the table. We will use the consumer vs. nonconsumer debt distinction below, as the launching pad for our discussion of § 706(b) motions.

2. Is Ability To Pay Cause?

Is ability to pay creditors grounds for a § 707(a) dismissal? Ninth Circuit case law is a bit thin on this question. In In re Motaharnia, 215 B.R. 63, 68 (Bankr. C.D. Cal. 1997) Judge Mund held: “There is no evidence that Congress intended for [ability to pay] to be considered cause under § 707(a).” See id. at n.9: “S. Rep. No. 989, 95th Cong., 2d Sess. 94 (1978). For an excellent analysis of why the ability to pay should not be considered as a factor in the ‘cause’ analysis under § 707(a) see In re Khan, 172 B.R. 613 (Bankr. D. Minn. 1994).” Although Motaharnia was pre-BAPCPA, § 707(a) remained unchanged after the 2005 amendments. Therefore, its reasoning has not been superseded by BAPCPA.

The Eighth Circuit Court of Appeals based its holding that ability to pay is not grounds for dismissal under § 707(a) on the legislative history:

The legislative history to § 707(a) is meager but does contain one comment that provides the core of Huckfeldt’s § 707(a) argument on appeal:

The section does not contemplate … that the ability of the debtor to repay his debts in whole or in part constitutes adequate cause for dismissal. To permit dismissal on that ground would be to enact a nonuniform mandatory chapter 13, in lieu of the remedy of bankruptcy.

H. R. Rep. No. 95-595, 95th Cong., 1st Sess. (1977), reprinted in 2 Collier on Bankruptcy App. 2, at II-380; S. Rep. No. 95-989, 95th Cong., 2d Sess. (1978), reprinted in 3 Collier on Bankruptcy App. 3, at V-94, U.S. Code Cong. & Admin. News 1978, p. 5787.

In re Huckfeldt, 39 F. 3d 829, 831 (8th Cir. 1994).

While there is more case law on subsection 707(a), covering it would take us beyond the scope of today’s discussion, so let’s turn instead to subsection 707(b).

B. The Means Test – Subsection 707(b)(2)

An important hurdle in most individual Chapter 7 cases is qualifying for Chapter 7 relief using a three-part test. The first two parts of the test are the so-called means test, which uses Form 122A. Form 122A is the embodiment of 11 U.S.C. § 707(b)(2).

The means test begins with “current monthly income” (“CMI”), the six-month arithmetic average of the debtor’s monthly household income from all sources for the six full calendar months prior to the month the debtor files the Chapter 7 petition. Well, almost all sources. 11 U.S.C. § 101(10A) defines “current monthly income.” Subsection 101(10A)(B)(ii) contains a few exclusions, the most common being social security income and COVID-19 stimulus payments.

In the first part of the test, the annualizes CMI by multiplying by 12, and compares the result to the median income in California for a family of the size of the debtor’s family. If the annualized CMI is less than the median, the debtor doesn’t need to complete the second part of the test. If the annualized CMI is greater than the median income, then the debtor must complete the second part of the test.

In the second part of the test, the debtor returns to current monthly income, but does not annualize. Instead, the debtor subtracts various amounts from current monthly income to calculate disposable monthly income (“DMI”) to determine how much is left over after subtracting taxes and reasonable living expenses, to pay creditors. If there’s nothing left over the debtor probably belongs in a Chapter 7. If there is money left over, then either the debtor must do some prebankruptcy planning involving changes in income and expenses, or consider filing under a different chapter.

To drill down one level without getting mired in the arithmetic details of the somewhat labyrinthine section 707(b)(2): The debtor subtracts the six-month average of taxes and social security the debtor paid over the relevant six-month period, the IRS standard monthly living expenses for a family of the debtor’s family’s size, and any additional living expenses not envisioned in the IRS standard expenses, but that the debtor can convince the U.S. Trustee and the judge are legitimate. When the smoke all clears, the result is DMI, which ideally should be negative to qualify for Chapter 7 protection. Of course, DMI can be a little bit positive, but I prefer filing with a negative DMI because filing with a positive DMI may serve to poke the beast with a sharp stick.

This statement regarding taxes isn’t quite right. According to page 6 of the STATEMENT OF THE U.S. TRUSTEE PROGRAM’S POSITION ON LEGAL ISSUES ARISING UNDER THE CHAPTER 7 MEANS TEST, the amount subtracted must be (emphasis added), “Based on monthly amount of actual taxes owed, not taxes withheld. Includes FICA, Social Security, Medicare, state and local taxes.” However, most of the time the six-month arithmetic average is correct.

C. The Totality Of Circumstances Test – Subsection 707(b)(3)(B)

The are two obvious artificialities in the means test.

The first is the use of a six-month average of gross rather than gross income on the petition date. If the debtor’s income recently dropped, the six-month average will overstate the debtor’s income while marching into the future. If the debtor’s income recently increased, the six-month average will understate future income.

The second artificiality is the use of IRS standard expenses. These IRS sumptuary limitations may bear little, if any, resemblance to the debtor’s actual living expenses.

As a consequence, the debtor still must complete Schedule I (income right now, rather than a six-month average) and Schedule J (real life living expenses rather than IRS standard living expenses). These two schedules can reveal excess available income not apparent in the means test, that renders a debtor ineligible for Chapter 7 relief under the totality of circumstances test of § 707(b)(3)(B).

For example, I have had clients who live with their parents rent-free, who passed the means test, but still had $1,000 per month left over after deducting taxes and living expenses.

D. Limitations On Dismissing A Chapter 7 Per Subsection 707(b)(1)

Subsection 707(b)(1) limits its scope to “a case filed by an individual debtor … whose debts are primarily consumer debts …” Thus, there are two types of Chapter 7 cases that cannot be dismissed using subsection 707(b). The first is a nonindividual case, and the second is a nonconsumer case.

The exclusion of nonindividual debtors is not much of a surprise because such debtors are not eligible for a Chapter 7 discharge. See 11 U.S.C. § 727(a)(1). Because nonindividual cases are not the focus of today’s post, I won’t discuss them further.

The exclusion of individual debtors whose debts are not primarily consumer debts is much more significant, and sets the stage for the alarming trend I mentioned at the beginning of this post. Since we aren’t dealing with nonindividual cases, for linguistic simplicity, I’ll refer to an individual case where the debts are not primarily consumer debts as a nonconsumer case.

By its very terms, subsection 707(b) does not apply to a nonconsumer case, so a nonconsumer debtor does not have to complete the means test. Pretty sweet, right?

But what if the difference between the Schedule I income and the Schedule J expenses (the “ IJ difference”) is a large positive number? Could the Court dismiss the case under the totality of circumstances test? The answer is no because § 707(b)(3) is still part of § 707(b), and is therefore inapplicable to a nonconsumer case.

This fact appears to have galled the U.S. Trustee’s Office, the IRS, and some creditors, and has led them to seek a way around the § 707(b)(1) limitation: Conversion to Chapter 11 under § 706(b). If the Court grants the motion to convert, then if the debtor fails to cooperate in the Chapter 11, the Court may dismiss that case, leading to the desired § 707(b) result without using § 707(b).

In the next post I’ll discuss consumer v. nonconsumer debts. It constitutes section II of this series. In the third post I’ll consider the § 706(b) question. And in the fourth post I’ll cover the thirteenth amendment implications of a § 706(b) motion in an individual debtor’s case.

 

(Note: James Selth and I made a presentation at a local bar association.  These are the notes we used.  Although I wrote the notes, some of the content came from a brief Jim filed in one of his cases.)

 

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The post The Fight Against An Alarming Trend: Section 706(b) Motions – Part 1 appeared first on Southern California Bankruptcy Law Blog.

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About the Author

Mr. Nicholas Gebelt represents debtors—individuals, couples, and Businesses—and helps them succeed in an area fraught with traps for the uninitiated.

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